Principles of Supply and Demand

Fundamentals of Demand

• Demand is defined as the willingness to buy a good or service coupled with the ability to pay for it.

• Law of Demand: There is an inverse relationship between price and quantity demanded.

  • When price goes up, quantity demanded goes down.

  • When price goes down, quantity demanded goes up.

• Law of Demand Example: Cheryl demands $3$ DVDs at a price of $\$15$ each, but demands $7$ DVDs when the price is $\$5$ each.

• Demand Schedule: A table listing how much of an item is demanded at various prices. Tables can represent an individual or a market (all consumers).

• Demand Curve: A graphical representation of the demand schedule where the vertical axis shows prices and the horizontal axis shows quantity. The curve typically slopes down from upper left to lower right.

Factors Shifting Demand

• A change in demand is caused by factors other than price, shifting the entire curve. Six primary factors include:

  • Income: Influences the ability to buy. Normal goods are demanded more as income rises; inferior goods are demanded less as income rises.

  • Market Size: Changes in the number of consumers (e.g., population shifts).

  • Consumer Tastes: Changes in the popularity of a good or service.

  • Consumer Expectations: Predictions of future price changes affect current buying habits.

  • Substitutes: Products used in place of others (e.g., water instead of soda).

  • Complements: Products used together (e.g., CD players and CDs).

Elasticity of Demand

• Elasticity of demand measures how responsive consumers are to price changes.

  • Elastic: Quantity demanded changes significantly as price changes.

  • Inelastic: Quantity demanded changes very little as price changes.

  • Unit Elastic: The percentage change in price and quantity demanded is the same.

• Determinants of Elasticity: Availability of substitutes, the proportion of income spent on the item, and whether the item is a necessity or a luxury.

  • Example: Insulin for diabetics is inelastic because it has no substitutes and is a necessity.

• Total Revenue Test: A method to determine elasticity using the formula $\text{Total Revenue} = P \times Q$.

  • If total revenue increases after a price drop, demand is elastic.

  • If total revenue decreases after a price drop, demand is inelastic.

Fundamentals of Supply

• Supply is the willingness and ability of producers to offer goods and services for sale.

• Law of Supply: Producers are willing to sell more of a product at a higher price than at a lower price.

• Law of Supply Example: The Smiths are willing to supply $24$ pounds of tomatoes at $\$1.00$ per pound, but $50$ pounds at $\$2.00$ per pound.

• Supply Curve: A graphical representation showing that quantity supplied increases as price increases (upward sloping).

Production Costs

• Fixed Costs: Expenses that do not change regardless of output (e.g., mortgage, insurance, manager salaries).

• Variable Costs: Expenses that change as the level of output changes (e.g., worker wages, electricity, materials).

• Total Cost: The sum of fixed and variable costs, calculated as $\text{Total Cost} = \text{Fixed Costs} + \text{Variable Costs}$.

Factors Shifting Supply and Elasticity

• Change in Supply: Occurs when producers offer different amounts at every price, shifting the curve. Factors include:

  • Input Costs: The price of resources used in production.

  • Labor Productivity: Efficiency of workers; increased by specialization and training.

  • Technology: Innovations that improve manufacturing efficiency.

  • Government Action: Excise taxes (taxes on production) decrease supply; regulations (safety laws) affect business behavior.

  • Producer Expectations and Number of Producers.

• Elasticity of Supply: Measures producer response to price changes.

  • Supply is inelastic if resources are limited, production is complex, or capacity cannot be easily increased.